2) accounting slides from the august 11 pre-course
TRANSCRIPT
MFin Pre-Course, Accounting
Accounting is one of the Foundations of Financial Decision Making
You will have two accounting courses during the MFin program
Today:
• Financial Statements: Examples, Q&A, Terminology
• Computing Cash Flows
• If time: Financial Ratios, Pro-Forma Statements
Note: this is not an accounting course!!!! The point of this is to cover some accounting concepts that are needed for finance. Also, I am not an accountant , but I do know what sort of accounting we need for finance …
Why do we need Accounting? What is so hard about it?
Financial statements contain information needed for financial decisions.
Example: Firm Value (V) = PV(Future Cash Flows)
Financial Statements provide the starting point for estimating CFs. Importantly, we are interested in future cash flows.
In addition, some accounting items affect r (e.g. D/E ratio).
Note: there is judgment involved in reading and interpreting financial statements. If there was one “correct” function that takes financial statements and computes expected future cash flows without judgment, then equity analysts would have been replaced by spreadsheet macros a long time ago. Hence, we must understand financial statements deeply!
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CF CFV
r r
The Income Statement
The Income Statement is a “story” about how the firm did over the year. It is a statement of “flows” in and out of the firm
Revenues 1000
COGS 200
SG&A 150
EBITDA 650
Depreciation 70
EBIT 580
Interest Expense 80
Pre-Tax Income 500
Tax Expense 150
Net Income 350
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The Income Statement
Comments:
1) There is no universally accepted structure to an income statement.
2) The income statement is NOT based on actual cash flows! Rather, once certain legal and economic events have taken place, revenues, costs, and income get recorded regardless of whether the actual cash has changed hands.
3) Firms have (some) discretion over when to recognize certain entries in the income statement and how to report certain transactions.
4) Income in one country is often very different from the same income recorded under another country’s accounting rules.
5) While Net Income (the ‘bottom line’ of the income statement) is important, it is not the only thing that matters – by a long shot!
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The Income Statement
The Income Statement (let’s look at a real one at Yahoo! Finance)
Do the following: for each line in the income statement, write down a very short definition and think of ONE thing that might make a simple interpretation of the number difficult.
Example: Taxes
Definition: the fraction of pre-tax income that the firm must pay to the government
Problem: this is NOT the money the firm actually has to pay in cash! In fact, this number is often quite different from the actual cash taxes owed depending on a country’s particular tax code and a firm’s particular tax situation.
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The Balance Sheet
The Balance Sheet is a “snap-shot” of a company’s financial position at a point in time. It is a statement listing “stocks” of value.
Cash & Equiv. 1000 Accounts Receivable 1000
Accounts Receivable 1500 Short Term Debt 3000
Inventories 3000 Total Curr. Liabilities 4000
Total Current Assets 5500 Long Term Debt 2500
PP&E 10000 Total Liabilities 6500
Accum. Depreciation 4000 Retained Earnings 3000
PP&E (Net) 6000 Paid In Capital 2000
Total Assets 11500 Total Liab. & Equity 11500
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The Balance Sheet
Comments
1) There is no universally accepted structure to a balance sheet.
2) The balance sheet entries are (often) at historical cost. Hence, they generally have very little to do with actual current market values
3) Some assets (but not all) are regularly written down or “depreciated” to record their loss in value over time. This loss in value is governed by accounting rules and has little to do with actual market values
4) Firms have discretion in when and how to reflect changes in the values of their assets. The “conservatism” principle often leads to asset impairments being recognized, but increases in asset values going “unnoticed”.
5) Again, accounting rules differ across countries – often dramatically!
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The Balance Sheet
The Balance Sheet (let’s look at a real one at Yahoo! Finance)
Do the following: for each line in the balance sheet, write down a very short definition and think of ONE thing that might make a simple interpretation of the number difficult.
Example: Cash and Cash Equivalents
Definition: the amount of cash (in transactions accounts) and very liquid investments the firm has
Problem: what the heck are ‘equivalents’? How about cash that is still in the account, but we know it must be paid to a supplier tomorrow for goods that have already been delivered?
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Income Statement & Balance Sheet: the relationship
Over time, net income (net of dividends) from the balance sheet are incorporated as “Retained Earnings” on the balance sheet.
But: changes in balance sheet entries are NOT necessarily reflected on the income statement (e.g. the sale of an asset for cash).
The Conclusion:
1) Use financial statements with care!
2) Understand both practices and rules before interpreting financial data
3) Nothing on accounting statements is (necessarily) cash, and therefore nothing has value in and of itself. Accounting data should be used to forecast cash flows – because cash flows is what investors pay for. In the end, cash flows and their values are the foundation for all real economic decisions.
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The Statement of Cash Flows
Unfortunately, the statement of cash flows does not contain the exact “cash flows” that we so desperately want for finance.
But, the statement of cash flows contains useful information that aide in the computation of the numbers we need in finance (e.g. Depreciation, Investment, …)
The statement of cash flows reconciles beginning and ending cash on the balance sheet through the “change in cash position”
Cash From Operations $120
Cash From Investment ($30)
Cash From Financing ($40)
Change in Cash Position $50
Let us look at a real-world statement of cash flows at Yahoo! Finance
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Free Cash Flows
The term “cash flow” gets thrown around quite a lot. There are many versions. The ‘basic’ cash flow that you need to know is as follows:
FCF = EBITDA × (1 - t) + Depreciation × t – CAPX – WC
= EBIT × (1 - t) + Depreciation – CAPX – WC
EBITDA×(1-t) + Depreciation × t is the after-tax cash flow from operations (sometimes called NOPAT – or net operating profit after taxes).
CAPX and WC (change in working capital) are investments the firm needs to make.
Note (1): there are alternate ways of computing FCF
Note (2): there are other cash flows (e.g. cash flows to equity, …)
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Cash Flows can be computed as follows
Revenues 1000- Costs 400= EBITDA 600 EBITDA×(1-t) 375+ Depreciation × t 19- Investment 120= CASH FLOWS 274
Getting Cash Flows: A Numerical Example
Information Given:
Revenues 1000
Costs 400
= EBITDA 600
Depreciation 50
= EBIT 550
Interest 150
= Pretax Income 400
Taxes 150
= Net Income 250
Assets (last year): 800
Assets (this year): 870 Now for real: Let’s compute IBM’s cash flows
for 2006 (get data from Yahoo Finance):
Note: if you have EBIT, you can use the fact that EBITDA = EBIT + Depreciation to get started
Financial Ratios I
Asset Turnover (Sales/Assets)
• Measures the efficiency with which assets are used to generate sales
• Sales is fairly ‘clean’ (more difficult to manipulate), even though firms have some leeway as to when to recognize sales
• Assets are a bit tricky. Many firms have found ways to remove assets that they use from their balance sheet – making them look more efficient
• This ratio can be used to help forecast future cash flows (e.g. suppose you believe that a firm’s efficiency is going to be improving at a rate of 1% per year for five years => if sales growth is projected at 5%, then asset growth can be backed out)
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Financial Ratios II
ROE (Net Income/Equity)
• Measures the profitability of a firm relative to the owner’s capital
• Net Income is a bit ‘dirty’ (firms can manipulate) and equity is not at all an indication of true economic capital (book equity is not driven by market prices – in fact it is often negative)
• Related ratios: ROA (Net Income over Assets), ROI (Net Income over Investment)
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Financial Ratios III
DuPont Identity
• NI/S measures the profitability of sales
• S/A measures the efficiency of asset use
• A/E measures financial leverage (recall: A = D+E, so A/E is equal to (D+E)/E = (1+D/E)
• The DuPont formula can be used to “deconstruct” a firm’s profitability. Often, the individual components are easier to analyze and forecast than the overall ROE.
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NI S AROE
S A E
Financial Ratios
P/E (Market Price / Earnings) – the “big one”
• Market Value Based
• Proxies for all sorts of things (growth, quality, value)
• P is probably pretty clean, E is a bit more dicey
• P/E is hard to compare between firms/industries/countries (it works better as a ‘time-series’ indicator)
• Related Ratios:
− M/B (Market Value – of the firm or of the equity – divided by the corresponding book value)
− EV/EBITDA (Enterprise value – at market prices – divided by EBITDA)
• A ‘mutant’ version: PEG (P/E divided by growth) – this one has almost no economically meaningful content
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Predicting Future Cash Flows
The point of using and understanding accounting data, which is by its very nature historical, in finance is to help us get what we really want: expected future numbers.
One way of predicting future cash flows is to look at what a firm did in the past and then extrapolate into the future (possible aided by additional information, economic models, intuition, …)
A (very simple!) example: using current and past financial statements, combined with a few assumptions, let’s construct some “pro-forma” financial statements. These will allow us to extract estimates of future cash flows and other forward looking numbers.
This is where it becomes clear very quickly that, despite all the hard numbers, finance is as much a science as it is an art …
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